What to know about consolidating student loans

Just yesterday, they were applying to college. And now they’ve graduated. Along with gaining a new degree, many graduates will also leave campus with new student loan payments they’ll have to fit into their post-graduate budgets. Consolidation provides grads with the ability to combine their student loans into one megaloan, but it comes with drawbacks. Here’s what you need to know before deciding to consolidate student loans.

How it works

Loan consolidation is when a borrower takes out a new loan to pay off several smaller student loans. Instead of making multiple payments to multiple lenders, the borrower only has to pay off the new consolidation loan, says Michelle Pezzulli, vice president of operations for Credit Union Student Choice, a student lending service provider in Washington, D.C.

“That new loan will have its own interest rate; it will have its own repayment terms; it will have its own terms and conditions,” she says. This can be attractive to borrowers because the consolidation frequently results in longer repayment periods and lower monthly payments.

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Consolidating federal student loans

When it comes to consolidation, the types of loans you have matters, but most federal loans, including Stafford, Perkins, Direct Plus and Supplemental loans, can be consolidated with other federal student loans.

“The interest rate on (federal) consolidation loans is an average of the interest rates on the (federal) loans you’re consolidating,” says Ken O’Connor, director of student advocacy for Fynanz, a New York City firm providing technology for the private student loan market. Even if your rates seem high, t he Department of Education puts a cap on consolidation loan rates at 8.25 percent.

One major advantage of federal consolidation loans is that borrowers don’t need a stellar credit score to qualify, they can apply any time (even if their loan is in default) at LoanConsolidation.ed.gov, and they’ll always get a fixed interest rate. Regardless of how the market fluctuates, borrowers will never pay more than 8.25 percent on their consolidation loans.

Private consolidation

Private loans can typically only be consolidated with other private loans. And once consolidated, they usually have variable interest rates, O’Connor says. So when you apply counts. Consolidating private student loans when interest rates are low (like now) “could potentially save thousands of dollars.” It also means your interest rate can fluctuate higher as the years tick by.

Unlike federal loans, it can be trickier to get your private loans consolidated. Private lenders require borrowers to pass a credit check to get the best rates. That means if your score isn’t superhigh, you could wind up paying more if you consolidate. It also means if you’re a new grad with little credit history, you might need a co-signer to be eligible. If a co-signer is necessary, O’Connor says borrowers should ask if there’s a co-signer release option after a certain period of time.

“With (our student loan program), if the borrower makes 12 months of on-time principal and interest payments, they can request to release the co-signer,” he says. “That creates tremendous flexibility, especially for families applying for loans for multiple kids.”

How to consolidate your student loan

Students consolidating federal loans can do so through the Department of Education’s website at Loan Consolidation.ed.gov, by phone at (800) 557-7392 or by downloading a paper application at LoanConsolidation.ed.gov/borrower/bapply.html and mailing it in. Almost all types of federal loans can be consolidated. Borrowers should have loan account numbers, estimated payoff dates and contact information for each of their loans’ holders ready. Those seeking consolidation should also review their repayment options at StudentAid.ed.gov, so they’re prepared to pick the proper repayment plan.

Once the application is submitted, the federal government estimates that it takes 60 to 90 days to officially complete the consolidation process.

Consolidating private loans works in a similar fashion, as far as paperwork goes. The difference is you’ll need to apply through a private lender. Some are better than others, so make sure to look at the varying terms of each one — staying away from charges or origination fees and checking the maximum interest rate so you won’t get burned down the road. Most also have limits on how much you can consolidate. Know that you might need a higher credit score if you want the best rates without a co-signer.

Borrower protections

Federal consolidation loans come with borrower protections private lenders may not offer. These include deferment — the ability to suspend payments under certain circumstances such as serving active military duty, attending further education or unemployment — and forebearance, which allows borrowers to postpone payments while still accruing interest, in cases of financial hardship. Federal loan borrowers can also lower their monthly payments by extending the life of their loan, having their payments capped according to their income and by having their debt dismissed after making 25 years of consecutive payments under the income-based repayment plan.

But borrower protections and repayment options on private consolidation loans can vary wildly from lender to lender. Betsy Mayotte, director of regulatory compliance for the student debt assistance group, American Student Assistance, makes sure to tell borrowers to stay away from consolidation loans that combine federal and private loans. Consolidating both types of loans excludes borrowers from federal protections. When eyeing consolidation options for private loans only, Mayotte says borrowers should evaluate the new loan’s hardship protections and repayment terms in addition to the interest rate.

“If the terms you’re going to get are the not as generous as the terms you already have, consolidation is probably not a good idea,” she says.

The consolidation catch

Regardless of whether consolidating federal or private loans, there is a catch. While loan consolidation can sometimes dramatically lower a borrower’s monthly payments, Kevin Walker, co-founder of the college finance site SimpleTuition.com, says it can also cost you.

“The downside of getting a lower monthly payment is that you’re going to subject yourself to substantially more interest charges over the life of the loan,” he says.

The silver lining is that all federal consolidation loans and some private ones don’t have prepayment penalties. Should borrowers pay off their loans early, they can save hundreds, sometimes thousands, in interest charges.

“Would it be nice to have just one loan where you make that one loan payment every month? Sure,” says Michelle Pezzulli, “… but at what price?”

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